Question

Suppose you consume two goods, X and Y. Suppose also: • Y is a normal good. • When the price of X goes up, you increase your consumption of Y. Illustrate the income and substitution effects on your consumption of Y. Which effect is bigger? Justify your answer.

please with a clear hand writing or typed

thank you

Answer 1

Answer : Based on given information, I am consuming good X and good Y both. Let initially I am consuming 1 unit of good X and 1 unit of good Y. Now, if my income increase then I spend more on good X and good X both and consume more. Let after increasing my income I am consuming 2 units of good X and 2 units of good Y. This situation is known as income effect. Now, after income effect if price of good X rise then I purchase more units of good Y instead of good X. As a result, let I am consuming 4 units of good Y and consuming nothing of good X due to rising price of good X. This situation is known as substitution effect.

Now from above discussion we get that the consumption of good Y increases by 1 unit due to income effect and increases by 2 units after income effect due to substitution effect. Therefore, here the substitution effect is bigger than income effect.